SAMPLE CHAPTER

Comprehensive Text,
Questions and Solutions

Enclosed is a sample of the material that is used in the

Lambers CPA Review courses worldwide.

The complete set of Lambers CPA Review course books consists of the following:

VOLUME 1 Financial Accounting and Reporting:

Business Enterprises (16 chapters)
VOLUME 2 Regulation (26 chapters)
VOLUME 3 Auditing (7 chapters)
VOLUME 4 Business Environment and Concepts
(14 chapters)

The entire set has over 2,000 pages including more than
2,400 questions, problems and simulations from the most recent CPA examinations.
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Excerpt from Volume 1—Financial Accounting and Reporting

Chapter Four
Consolidated Financial Statements
As a prelude to the study of consolidations, it is helpful to look at the terminology involved and the methods for accounting for
investments in common stock.

Terminology
Normally for investments in which the investor does not have control, the investor is called the investor and the company
invested in is called the investee. In situations in which the investor has control, the investor is called the parent and the
company invested in is called the subsidiary.

Methods of Accounting for Investments in Common Stock

Percent of Level of Balance
Common Stock Influence Valuation of sheet
Owned (assumed) Investment Presentation Income
<20 Lacks significant Cost/Fair Value Investment Dividends
20 - 50 Significant Equity Investment % share
>50 Control Either Eliminate in consolidation Eliminate in consolidation

Investments in Common Stock – Cost vs Equity Methods

As noted on the chart, the parent company may use either the cost or equity method for recording the investment in the
subsidiary because the investment account is eliminated in consolidation and does not appear on the consolidated balance sheet.
Dividend revenue recorded by the parent on the cost method or equity in subsidiary’s income recorded by the parent is also
eliminated by the consolidation process. Candidates should know the mechanics of both methods to understand the eliminating
entries on the consolidation worksheet.

Cost Method
In using the chart, please note that it states that if the investor owns less than a 20% interest in the common stock of the investee, the
cost method is used. This is a guide, not a rule. The rule is that the investor lacks significant influence. For example, ABC owns
15% of XYZ. ABC is the largest stockholder in XYZ and ABC’s officers are a majority of the board-of-directors of XYZ. These two
items give ABC significant influence in the operations of XYZ; therefore the investment would be recorded using the equity method
instead of the cost method even though the ownership interest of 15% is less than the 20% guide indicated by the chart.

In reality, many of these investments in which the investor has no significant influence are reported at fair value, not cost. In
Chapter 2, fair value is required if the investments in common stock of the investee meets the definition of a marketable equity
security. In Chapter 7, under SFAS 159 the company has the option of reporting the investment at fair value. However, if the
investment does not meet the definition of a marketable equity security or the fair value option is not used, the investment should
be recorded at cost.

Note: The emphasis on the cost method in this chapter is because it is used in consolidations.

Author’s Note: In the following examples, I will use the term investee because most of my illustrations will use investments
below 50%. If the examples included investments above 50%, I would use the term subsidiary.

Journal Entries for the Cost Method

A. JE To record the acquisition at cost
JE Investment investee (cost) XX
Cash XX
B. To record the investors share of the investee’s cash dividend
JE Cash XX
Dividend Revenue XX
Note: The receipt of a stock dividend from the investee does not change the total cost of the investment and is not dividend
revenue. The stock dividend simply changes the average cost per share (basis) and is recorded using a (memo) entry.

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Equity Basis
The chart indicates that an investment in the common stock of another company that gives the investor significant influence over
the operations of the investee should be recorded using the equity basis. The theory of the equity method is that the investor
should reflect on its books its share of changes occurring on the books of the investee.

For example: On January 2, Year 4. ABC purchased 40% of the outstanding stock of XYZ for $450,000. The carrying amount
of XYZ’s net assets (assets – liabilities) on the purchase date was $920,000. Fair values and carrying values were the same for all
items except plant and inventory for which fair values exceeded their carrying amounts by $80,000 and $10,000 respectively.
The plant had a 20 year life and all the inventory was sold in Year 4. During Year, XYZ reported net income of $150,000 and
paid a cash dividend of $30,000.

Equity Method – Normal Journal Entries

A. To record the investment in the investee at cost

JE Investment in investee (cost) 450,000

Cash 450,000

B. To record the investor’s share of the investee’s income (40% x $150,000 = $60,000).

JE Investment in investee 60,000

Equity in NI of investee 60,000

Reflecting Theory: The investee’s assets increased from the net income; therefore, ABC’s asset , investment in investee, should
reflect the increase. The investee’s income statement increased because it had net income. Therefore, ABC’s income statement
account, Equity in Net Income of Investee, should reflect the increase for its 40% share of the investee’s income.

C. To record the investor’s share of the investee’s dividends (40% x $30,000 = $12,000).

JE Cash 12,000
Investment in investee 12,000

Reflecting Theory: The investee paid a cash dividend, so its assets decreased. Therefore, ABC’s asset account, Investment in
Investee, should reflect this decrease.

D. The fourth common entry using the equity method is the most complicated. It involves a situation in which the cost of
the investment includes goodwill and undervalued or overvalued assets and/or liabilities.

In the ABC example, the investee’s plant is undervalued by $80,000. ABC’s share of the undervaluation is $32,000
(40% x $80,000). Remember the investee calculated depreciation expense included in its $150,000 net income based
on the plants carrying value. Since ABC paid fair value for its 40% share of the plant, it should record additional
depreciation on the $32,000. The additional depreciation should be $32,000 divided by the 20 year useful life for a
total of $1,600 per year.

The same theory applies to the undervalued inventory. The investee included the book value of the cost of the
inventory sold in its calculation of the $150,000 in net income. Since ABC paid fair value for its share of the
additional cost of the inventory ($10,000 x 40% = $4,000), the $4,000 should be added to the cost of goods sold.

Therefore, Journal Entry “D” should include the combined total of the $1,600 additional depreciation plus the $4,000
additional cost of goods sold for a combined total of $5,600.

JE Equity in NI – Investee 5,600

Investment in Investee 5,600

The final ledger accounts should appear as follows:

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 Investment in Investee

A) Cost 450,000 C) Share of dividends 12,000

B) Share of Net Income 60,000 D) Additional depreciation 1,600

D) Additional cost of goods sold 4,000

December 31, Yr. 4 balance 492,400

Equity in Net Income – Investee

D) Additional depreciation ` 1,600 A) Share of net income 60,000

D) Additional cost of goods sold 4,000

Dec. 31, Yr. 4, balance 54,400

Goodwill
Occasionally the candidate will be required to calculate the amount of goodwill included in the cost of the investment in the
investee. The calculation is as follows:

Price paid for investee $450,000

vs
ABC’s share of the fair value of the investee’s net assets

Book value of net assets

40% x $920,000 = $368,000

Plus undervalued plant

40% x $80,000 = 32,000

Plus undervalued inventory

40% x $10,000 = 4,000

Total fair value of investee’s net assets (404,000)

Goodwill $ 46,000

Note: Candidates may be confused because there is no mention of testing goodwill for impairment. SFAS 142 states that
goodwill implicit in equity method investments will not be tested for impairment. However like all assets, equity method
investments (not just the goodwill portion) will be tested for permanent declines in value.

Equity Method when the Investee has Preferred Stock

If the investee (XYZ) had a $20,000 preferred dividend, ABC would calculate its share of XYZ’s income based on the income
available to common shareholders. (Similar to the calculation of Earnings per Share.) The income available to common share-
holders would be investee’s net income of $150,000 less the preferred income of $20,000 for a net of $l30,000. Therefore,
ABC’s share of XYZ’s net income would be 40% x $130,000 = $52,000.

Special Problems – Cost vs Equity

Converting from equity method to cost method: The conversion from equity to cost is very simple. For example, ABC
purchased 40% interest in XYZ in Year 3 for $500,000 and recorded the investment on the equity basis. When the balance in the

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investment account on July 1, Year 4 was $540,000 and the balance in the equity in net income of the investee was $60,000,
ABC sold a portion of its investment ($300,000) for $320,000 which reduced its interest in XYZ to 15%. XYZ’s income for the
last 6 months of Year 4 was $100,000. On December 1, Year 4, XYZ paid dividends of $50,000. The ledger (T-accounts) are as
follows:

Investment in Investee – XYZ

July 1, Year 4 balance 540,000 July 1, Year 4 sold 300,000

Dec. 31, Year 4 balance 240,000

Equity in Net Income – Investee XYZ

July 1, Year 4 share of income 60,000

Dividend Revenue

Dec. 1, Year 4 share of dividends 7,500

Gain on Sale of Investment

July 1, Year 4 JE 20,000

The Journal Entry for the sale of the investment is as follows:

July 1, Year 4 JE Cash 320,000

Investment in Investee – XYZ 300,000
Gain on Sale of Investment 20,000

After the July 1, Year 4 Journal Entry, ABC’s investment was reduced to 15%. At that point ABC automatically switched to the
cost basis. So on December 1, Year 4 it would record its share of XYZ’s cash dividend (15% x $50,000 = $7,500) as a debit to
cash and a credit to dividend revenue.

To summarize, ABC would report on its balance sheet a long-term investment in XYZ of $240,000 and report on the income
statement in the equity in net income of the investee account $60,000 for the first 6 months of Year 4 and dividend revenue of
$7,500 for the last 6 months of the year and gain on sale of investment of $20,000.

Chapter Four contains additional text that has been omitted from this sample chapter.

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Excerpt from Volume 1—Financial Accounting and Reporting
Chapter Four
Consolidated Financial Statements Questions
COST METHOD
1. Day Co. received dividends from its common
stock investments during the year ended December
31, Year 2, as follows:
• A stock dividend of 400 shares from Parr Corp.
on July 25, Year 2, when the market price of
Parr's shares was $20 per share. Day owns less
than 1% of Parr's common stock.
• A cash dividend of $15,000 from Lark Corp. in
which Day owns a 25% interest. A majority of
Lark's directors are also directors of Day.
What amount of dividend revenue should Day report
in its Year 2 income statement?
a. $23,000
b. $15,000
c. $8,000
d. $0
EQUITY METHOD
2. On July 1, Year 3, Denver Corp. purchased 3,000
shares of Eagle Co.’s 10,000 outstanding shares of
common stock for $20 per share. On December 15,
Year 3, Eagle paid $40,000 in dividends to its
common stockholders. Eagle’s net income for the
year ended December 31, Year 3, was $120,000,
earned evenly throughout the year. In its Year 3
income statement, what amount of income from this
investment should Denver report?
a. $36,000
b. $18,000
c. $12,000
d. $6,000
3. On January 2, Year 2, Well Co. purchased 10% of
Rea, Inc.'s outstanding common shares for $400,000.
Well is the largest single shareholder in Rea, and
Well's officers are a majority on Rea's board of
directors. Rea reported net income of $500,000 for
Year 2, and paid dividends of $150,000. In its
December 31, Year 2, balance sheet, what amount
should Well report as investment in Rea?
a. $450,000
b. $435,000
c. $400,000
d. $385,000
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4. On January 1, Year 4, Barton Corporation
acquired as a long-term investment for $500,000, a
30% common stock interest in Buffer Company. On
that date, Buffer had net assets with a book value and
current market value of $1,600,000. During Year 4
Buffer reported net income of $180,000 and declared
and paid cash dividends of $40,000. What is the
amount of income that Barton should report from this
investment for Year 4?
a. $12,000.
b. $42,000.
c. $53,500.
d. $54,000.
5. Sage, Inc., bought 40% of Adams Corp.’s
outstanding common stock on January 2, Year 2, for
$400,000. The carrying amount of Adams’ net assets
at the purchase date totaled $900,000. Fair values and
carrying amounts were the same for all items except
for plant and inventory, for which fair values
exceeded their carrying amounts by $90,000 and
$10,000, respectively. The plant has an 18-year life.
All inventory was sold during Year 2. During Year 2,
Adams reported net income of $120,000 and paid a
$20,000 cash dividend. What amount should Sage
report in its income statement from its investment in
Adams for the year ended December 31, Year 2?
a. $48,000
b. $42,000
c. $36,000
d. $32,000
6. Park Co. uses the equity method to account for its
January 1, Year 4, purchase of Tun Inc.'s common
stock. On January 1, Year 4, the fair values of Tun's
FIFO inventory and land exceeded their carrying
amounts. How do these excesses of fair values over
carrying amounts affect Park's reported equity in
Tun's Year 4 earnings?
Inventory excess Land excess
a. Decrease Decrease
b. Decrease No effect
c. Increase Increase
d. Increase No effect
Items 7 through 9 are based on the following: 11. On January 1, Year 2, Mega Corp. acquired 10%
of the outstanding voting stock of Penny, Inc. On
Grant, Inc. acquired 30% of South Co.'s voting stock
January 2, Year 3, Mega gained the ability to
for $200,000 on January 2, Year 2. Grant's 30%
exercise significant influence over financial and
interest in South gave Grant the ability to exercise
operating control of Penny by acquiring an additional
significant influence over South's operating and
20% of Penny’s outstanding stock. The two
financial policies. During Year 2, South earned
purchases were made at prices proportionate to the
$80,000 and paid dividends of $50,000. South
value assigned to Penny’s net assets, which equaled
reported earnings of $100,000 for the six months
their carrying amounts. For the years ended
ended June 30, Year 3, and $200,000 for the year
December 31, Year 2 and Year 3, Penny reported the
ended December 31, Year 3. On July 1, Year 3,
following:
Grant sold half of its stock in South for $150,000
cash. South paid dividends of $60,000 on October 1, Year 2 Year 3
Year 3. Dividends paid $200,000 $300,000
Net income 600,000 650,000
7. Before income taxes, what amount should Grant
include in its Year 2 income statement as a result of In Year 3, what amounts should Mega report as
the investment? current year investment income and as an adjustment,
a. $15,000 before income taxes, to Year 2 investment income?
b. $24,000
Year 3 Adjustment to
c. $50,000
investment Year 2 investment
d. $80,000
income income
a. $195,000 $160,000
8. In Grant's December 31, Year 2, balance sheet,
b. $195,000 $100,000
what should be the carrying amount of this
c. $195,000 $40,000
investment?
d. $105,000 $40,000
a. $200,000
b. $209,000
12. When the equity method is used to account for
c. $224,000
investments in common stock, which of the
d. $230,000
following affect(s) the investor's reported investment
income?
9. In its Year 3 income statement, what amount
A change
should Grant report as gain from the sale of half of
in market value Cash dividends
its investment?
of investee's common stock from investee
a. $24,500
a. Yes Yes
b. $30,500
b. Yes No
c. $35,000
c. No Yes
d. $45,500
d. No No
_____________

10. Moss Corp. owns 20% of Dubro Corp.'s preferred

CONSOLIDATION—GOODWILL
stock and 80% of its common stock. Dubro's stock
outstanding at December 31, Year 2, is as follows:
13. Penn Corp. paid $300,000 for the outstanding
common stock of Star Co. At that time, Star had the
10% cumulative preferred stock $100,000
following condensed balance sheet:
Common stock 700,000
Carrying
amounts
Dubro reported net income of $60,000 for the year
Current assets $ 40,000
ended December 31, Year 2. What amount should
Plant and equipment, net 380,000
Moss record as equity in earnings of Dubro for the
Liabilities 200,000
year ended December 31, Year 2?
Stockholders’ equity 220,000
a. $42,000
b. $48,000
The fair value of the plant and equipment was
c. $48,400
$60,000 more than its recorded carrying amount. The
d. $50,000

4Q-2
fair values and carrying amounts were equal for all 16. In a business combination accounted for as a
other assets and liabilities. purchase, the appraisal values of the identifiable
In addition, Penn paid $20,000 in accounting, assets acquired exceeds the acquisition price. The
attorney and investment banker fees directly excess appraisal value should be reported as a
associated with the acquisition. a. Deferred credit.
What amount of goodwill, related to Star’s b. Reduction of the values assigned to current
acquisition, should Penn report in its consolidated assets and a deferred credit for any unallocated
balance sheet? portion.
a. $20,000 c. Gain on bargain purchase.
b. $40,000 d. Pro rata reduction of the values assigned to
c. $60,000 current and noncurrent assets.
d. $80,000

CONSOLIDATION THEORY
14. On April 1, Year 4, Dart Co. paid $620,000 for
all the issued and outstanding common stock of Wall 17. Which of the following is the best theoretical
Corp. in a transaction properly accounted for as a justification for consolidated financial statements?
purchase. The recorded assets and liabilities of Wall a. In form the companies are one entity; in
Corp. on April 1, Year 4, follow: substance they are separate.
b. In form the companies are separate; in
Cash $ 60,000
substance they are one entity.
Inventory 180,000
c. In form and substance the companies are one
Property and equipment (net of
entity.
accumulated depreciation of
d. In form and substance the companies are
$220,000) 320,000
separate.
Goodwill (net of accumulated
amortization of $50,000) 100,000
Liabilities (120,000)
18. When a parent-subsidiary relationship exists,
Net assets $540,000
consolidated financial statements are prepared in
recognition of the accounting concept of
On April 1, Year 4, Wall's inventory had a fair value
a. Reliability.
of $150,000, and the property and equipment (net)
b. Materiality.
had a fair value of $380,000. What is the amount of
c. Legal entity.
goodwill resulting from the business combination?
d. Economic entity.
a. $150,000
b. $120,000
c. $50,000
19. Company X acquired for cash all of the
d. $20,000
outstanding common stock of Company Y. How
should Company X determine in general the amounts
to be reported for the inventories and long-term debt
15. On June 30, Year 4, Needle Corporation
acquired from Company Y?
purchased for cash at $10 per share all 100,000
shares of the outstanding common stock of Thread Inventories Long-term debt
Company. The total appraised value of identifiable a. Fair value Fair value
assets less liabilities of Thread was $1,400,000 at b. Fair value Recorded value
June 30, Year 4, including the appraised value of c. Recorded value Fair value
Thread's property, plant, and equipment (its only d. Recorded value Recorded value
noncurrent asset) of $250,000. The consolidated
financial statement of Needle Corporation and its
wholly owned subsidiary at June 30, Year 4, should
reflect
a. An extraordinary gain of $150,000. Chapter Four contains additional questions,
b. An ordinary gain of $400,000. problems and simulations
c. An extraordinary gain of $400,000. that have been omitted from this sample chapter.
d. Goodwill of $400,000.

4Q-3
Excerpt from Volume 1—Financial Accounting and Reporting

Chapter Four
Solutions to Consolidated Financial Statements
Questions
1. (d) $0 dividend revenue. Receipt of a stock dividend (usually) does not constitute dividend income to the
investor, rather it reduces the cost basis per share of the investment. Therefore, the 400 shares received as a stock
dividend from Parr Corp. would not be included in dividend income.

2. (b) Denver Corp. acquired 30% of Eagle Company’s outstanding common stock. With no evidence to the
contrary, an investment of 20% or more is assumed to give significant influence, and would be accounted for using
the equity method. Under the equity method the investor recognizes in income its share of the investee’s net income
or loss subsequent to the date of acquisition.
Investment income = $120,000 × 30% × 1/2 year = $18,000

3. (b) $435,000. The equity method of accounting for investments in common stock should be used if the investor
has significant influence over the operating and financial policies of the investee. Well Company's significant
influence is demonstrated in its officers being a majority of the investees' board of directors.

Original cost of investment $400,000

Add: Share of income subsequent to acquisition
10% x $500,000 50,000
Less: Dividend of investee
10% x $150,000 (15,000)
$435,000
4. (c) $54,000.
Cost of investment $500,000
FV of net assets purchased—30% × $1,600,000 480,000
Goodwill $ 20,000
Buffer's net income $180,000
Barton's share (30% × $180,000) $54,000

Note: Candidates may be confused because there is no mention of testing goodwill for impairment. SFAS 142 states
that goodwill implicit in equity method investments will not be tested for impairment. However, like all assets,
equity method investments (not just the goodwill portion) will be tested for permanent declines in value.

5. (b) $42,000 income from investment in Adams. Under the equity method the investor recognizes in income its
share of the investee’s net income or loss subsequent to the date of acquisition. Furthermore, the investor should
reflect adjustments which would be made in consolidation, based on the investor’s percentage ownership, if such
adjustments (eliminations) can be recorded between investment income and the investment account.
Sage’s share of Adams’ net income (40% × $120,000) $48,000
Less: Amortization of depreciable assets fair value
in excess of book value
$90,000 ÷ 18 yrs. × 40% (2,000)
Fair value of inventory in excess of book value
charged to cost of goods sold
$10,000 × 40% (4,000)
Income from investment in Adams $42,000
There was no goodwill resulting from the investment.

4S-1
 Cost of investment $400,000
Fair value of net assets acquired
Book value $ 900,000
Fair value in excess of book value
Plant 90,000
Inventory 10,000
Fair value of net assets 1,000,000
% acquired × 40% 400,000
Goodwill —0—

6. (b) Under the equity method, the investor should reflect adjustments which would be made in consolidation,
based on the investor's percentage ownership, if such adjustment (eliminations) can be recorded between investment
income and the investment account. The fair value of the FIFO inventory in excess of the carrying value would
reduce net income of the investee, therefore, the investor would charge investment income and credit the investment
account to reflect the decrease in income. The fair value of the land in excess of its carrying value would not affect
income as it is not a depreciable asset. No adjustment would be made relative to the land.

7. (b) $24,000 Investment income. As Grant's investment gives it the ability to exercise significant influence over
South's operating and financial policies, the equity method would be used to account for the investment. Grant's
equity in South's income is $24,000 (30% x $80,000 income).

8. (b) $209,000 Investment carrying value at 12/31/YR2

Original cost $200,000
Add: Equity in South's income (#7) 24,000
Less: Dividends received (30% x $50,000) (15,000)
Carrying value 12/31/YR2 $209,000

9. (b) $30,500 Gain on sale of investment.

Carrying value 12/31/YR2 (#8) $209,000
Add: Equity in South's income 1/1 to 7/1/YR3
30% x $100,000 30,000
Carrying value 7/1/YR3 $239,000
1/2 investment carrying value $119,500
Sales proceeds on 1/2 of investment 150,000
Gain on sale of investment $ 30,500
Note: As investment is now reduced to 15%, it will be accounted for by the cost method (assuming no significant
influence).

10. (a) $42,000. When an investee has cumulative preferred stock outstanding, an investor should compute its share
of investee's earnings after deducting the preferred dividends, whether or not such dividends are declared.

Equity in earnings applicable to common stock

Net income $60,000
Less: Preferred dividends ($100,000 par x 10%) 10,000
Net income applicable to common stock $50,000
Moss' percentage ownership (common) x 80%
Moss' equity in earning applicable to common stock $40,000
Equity on earnings applicable to Preferred Stock
Preferred dividend $10,000
Moss' percentage ownership (preferred) x 20% 2,000

Moss' equity in Dubro's earnings $42,000

Chapter Four contains additional answers that have been omitted from this sample chapter.

4S-2
Excerpt from Volume 2—Regulation

Chapter One
Filing Status and Exemptions, Filing Requirements
and Penalties
OVERVIEW TO INDIVIDUAL TAXATION
The taxation of individuals starts with a very basic formula:

Gross income
Minus deductions
Equals taxable income

In our first four chapters, you will examine what makes up the gross income and allowable deductions of
individuals. The CPA examination will test you on various components of the income and deductions, as well as
various methods of determining the tax and a host of tax credits.

This very basic formula will expand as you are introduced to various classifications of deductions. You will be
exposed to limitations on certain deductions based upon thresholds or ceilings, as well as phaseouts for exemptions
and special rates. To be sure, there is a lot of complexity. But in the end, it comes back to income minus
deductions equals taxable income.

In broad terms, gross income includes all items of income, unless specifically excluded by the Internal Revenue
Code. By contrast, nothing is deductible unless specifically allowed by the Code. As a result, you will find that
Chapter 2, which deals with inclusions and exclusions of income, is relatively short in comparison to the size of
Chapters 3 and 4, which deal with the various deductions.

To help you better understand Chapter 1 and what lies ahead, follow through this simple example.

Example 1: K is single, aged 63 and earned $12,000 working part-time. In addition, K earned
interest income of $1,300 and dividend income of $650. K also received social security benefits
this year of $2,000. K does not itemize her deductions.

K’s taxable income for 2008 is computed as follows:

Salary income $ 12,000

Interest income 1,300
Dividend income 650
Total gross income 13,750
Less: Standard deduction (5,450)
Less: Personal exemption (3,500)
Taxable income $ 5,000

K’s gross income, as more fully explained in Chapter 2, is comprised of salary, interest and dividend income.
Social security benefits are not included in gross income unless they pass a threshold test as you will learn about
later. Since K does not “itemize” her deductions, she is allowed a standard amount of deductions. You will learn
more about itemized deductions in Chapter 4. For 2008, the standard deduction is $5,450 for single taxpayers.
The amount of the standard deduction is based upon the filing status of the taxpayer. This is addressed in this
chapter. The other deduction is the personal exemption and for 2008 it is $3,500. This, too, is discussed in this
chapter.

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This is the most comprehensive problem you need to understand in this chapter. Now let’s look at the taxpayer’s
Filing Status and Exemptions in detail.

FILING STATUS

There are five filing statuses available to individual taxpayers. A taxpayer may choose any status he qualifies for.
Since filing status determines your tax rate structure (See Chapter 5 for the complete rate structure) and the amount
of your standard deduction, choosing the proper filing status is important in minimizing your taxes.

1. Single, or unmarried. If a taxpayer is unmarried on the last day of the tax year, or is separated by a decree
of divorce or separate maintenance, that taxpayer is considered single. Assuming the taxpayer does not qualify for a
more favorable filing status such as head of household, or qualifying widower, the taxpayer must file as a single
taxpayer.

2. Married Filing Jointly. To qualify for this status, the taxpayer must be married as of the last day of the
year. In the event of the death of the spouse during the year, the spouse need only be alive on the first day of that
year in order to qualify as being married for the entire year. Taxpayers are prohibited from filing jointly if their
spouse is a non-resident alien or they have different tax year-ends from one another. Couples filing jointly may use
different accounting methods in filing their joint return. A further discussion of these accounting methods can be
found in Chapter 5. For federal tax purposes, a marriage means only a legal union between a man and a woman as
husband and wife.

3. Married Filing Separately. Married taxpayers may elect to file separate returns for a number of reasons.
Issues of privacy, disclosure of tax returns by public officials, and possible tax planning in the shifting of deductions
are some reasons as to why this status is available. In filing a separate return, both taxpayers must agree to either
claiming (splitting) the standard deduction, or itemizing their deductions. One cannot itemize and the other claim
the standard deduction.

4. Head of Household. This status is available to an unmarried taxpayer who:

1. maintains a household and provides for more than 50% of the year the cost for
2. your qualifying child (see page 5) or any other relative who is a dependent
(as is discussed under exemptions) as a member of his household.

In determining the cost of maintaining the household, you would include the cost of the food consumed in the home,
as well as mortgage interest and real estate taxes (or rent), utilities and repairs. A special exception to this rule is that
the taxpayer’s parents are not required to live with the taxpayer. The taxpayer must maintain more than 50% of the
parent’s home, or more than 50% of their nursing home costs, in order to qualify. The parent must also qualify as
the taxpayer’s dependent.

5. Qualifying widow(er) with dependent child. This is also referred to as surviving spouse. If your
spouse dies during the taxable year, you are entitled to file married, filing jointly for that year. In the two years
following the death of your spouse, the taxpayer may elect qualifying widow(er) if:

1. The taxpayer has not remarried, and

2. maintains more than 50% of the cost of the home where,
3. the dependent child resides for the entire year.

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STANDARD DEDUCTION

Once the determination of the appropriate filing status has been made, the amount of the standard deductions are as
follows:

2008
Single, or unmarried $5,450
Married, filing jointly 10,900
Married, filing separately 5,450
Head of household 8,000
Qualifying widow(er) 10,900

You do not need to memorize these amounts. On past exams the candidate has been provided with these amounts as
needed. You should, however, understand how amounts change in relation to one another. For example, married
filing separately is exactly one-half of the married filing jointly. Qualifying widower provides a larger deduction
than head of household. This relationship is important should the examiners ask you to determine what the most
beneficial filing status is.

ADDITIONAL STANDARD DEDUCTION

There is an additional standard deduction available to the taxpayer who is 65 years or older, or blind. The
additional standard deduction is added to the regular standard deduction in the determination of taxable income.
The amounts are as follows:

2008
Single or head of household $ 1,350
Married or surviving spouse 1,050

Example 2: K is single, 67 and blind. For 2008, she is entitled to a total standard deduction of:

Regular standard deduction $ 5,450

Additional standard deductions:
65 or over 1,350
Blind 1,350
Total standard deduction $ 8,150

Chapter One contains additional text that has been omitted from this sample chapter.

1-3
Excerpt from Volume 2—Regulation

Chapter One — Questions

Filing Status and Exemptions, Filing Requirements
and Penalties

Filing Status

1. John and Mary Arnold are a childless, married couple
who lived apart (alone in homes maintained by each)
the entire year. On December 31, 2008, they were
legally separated under a decree of separate
maintenance. Which of the following is the only filing
status choice available to them when filing for 2008?
a. Single.
b. Head of household.
c. Married filing separate return.
d. Married filing joint return.
5. Emil Gow's wife died in 2006. Emil did not remarry,
and he continued to maintain a home for himself and his
dependent infant child during 2007 and 2008, providing
full support for himself and his child during these years.
For 2008, Emil's filing status is
a. Single.
b. Head of household.
c. Qualifying widower with dependent child.
d. Married filing joint return.

2. A husband and wife can file a joint return even if
a. The spouses have different tax years, provided that
both spouses are alive at the end of the year.
b. The spouses have different accounting methods.
c. Either spouse was a nonresident alien at any time
during the tax year, provided that at least one spouse
makes the proper election.
d. They were divorced before the end of the tax year.
6. Which of the following is(are) among the
requirements to enable a taxpayer to be classified as a
"qualifying widow(er)" ?
I. A dependent has lived with the taxpayer for six
months.
II. The taxpayer has maintained the cost of the
principal residence for six months.

3. During 2008 Robert Moore, who is 50 years old and a. I only.

unmarried, maintained his home in which he and his b. II only.
widower father, age 75, resided. His father had $4,000 c. Both I and II.
interest income from a savings account and also d. Neither I nor II.
received $2,400 from social security during 2008.
Robert provided 60% of his father's total support for
2008. What is Robert's filing status for 2008, and how
many exemptions should he claim on his tax return? Exemptions
a. Head of household and 2 exemptions. 7. Mark Erickson, age 46, filed a joint return for 2008
b. Single and 2 exemptions. with his wife Helen, age 24. Their son John was born
c. Head of household and 1 exemption. on December 16, 2008. Mark provided 60% of the
d. Single and 1 exemption. support for his 72-year-old widowed mother until April
10, 2008, when she died. His mother's only income was
4. Murray Richman, who is 60 years old and unmarried, from social security benefits totaling $2,200 during
was the sole support of his aged mother. His mother 2008. How many exemptions should the Erickson's
was a resident of a home for the aged for the entire year claim on their 2008 tax return?
and had no income. What is Richman's filing status, and a. 2.
how many exemptions should he claim on his tax b. 3.
return? c. 4.
a. Head of household and 2 exemptions. d. 5.
b. Single and 2 exemptions.
c. Head of household and 1 exemption.
d. Single and 1 exemption.

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8. Jim and Kay Ross contributed to the support of their a. Only his wife.
two children, Dale and Kim, and Jim's widowed parent, b. Only his father's brother.
Grant. For 2008, Dale, a 19-year old full-time college c. Only his cousin.
student, earned $4,500 as a baby-sitter. Kim, a 23-year d. His wife, his father's brother, and his cousin.
old bank teller, earned $12,000. Grant received $5,000
in dividend income and $4,000 in nontaxable social 12. Mary Dunn provided 20% of her own support; the
security benefits. Grant, Dale, and Kim are U.S. citizens remaining 80% was provided by her three sons as
and were over one-half supported by Jim and Kay. How follows:
many exemptions can Jim and Kay claim on their 2008
Bill 15%
joint income tax return?
Jon 25%
a. Two.
Tom 40%
b. Three.
80%
c. Four.
d. Five.
Assume that a multiple support agreement exists and
that the brothers will sign multiple support declarations
as required. Which of the brothers is eligible to claim
9. Mr. and Mrs. Brook, both age 62, filed a joint return
the mother as a dependent?
for this taxable year. They provided all the support for
a. None of the brothers.
their son who is 19, legally blind, and who had no
b. Tom only.
income. Their daughter, age 21 and a full-time student
c. Jon or Tom only.
at a university, had $4,200 of income and provided 70%
d. Bill, Jon or Tom.
of her own support. How many exemptions should Mr.
and Mrs. Brook have claimed on their joint income tax
13. Sara Hance, who is single and lives alone in Idaho,
return?
has no income of her own and is supported in full by the
a. 5.
following persons:
b. 4.
Amount Percent
c. 3.
of of
d. 2.
support total
Alma (an unrelated
friend) $2,400 48
10. Albert and Lois Stoner, age 66 and 64, respectively,
Ben (Sara's brother) 2,150 43
filed a joint tax return for this taxable year. They
Carl (Sara's son) 450 9
provided all of the support for their blind 19-year-old
$5,000 100
son, who has no gross income. Their 23-year-old
daughter, a full-time student until her graduation on
Under a multiple support agreement, Sara's dependency
June 14, earned $2,000, which was 40% of her total
exemption can be claimed by
support during the year. Her parents provided the
a. No one.
remaining support. The Stoner's also provided the total
b. Alma.
support of Lois' father, who is a citizen and life-long
c. Ben.
resident of Peru. How many exemptions can the
d. Carl.
Stoner's claim on their income tax return?
a. 4.
14. Joe and Barb are married, but Barb refuses to sign a
b. 5.
2008 joint return. On Joe's separate 2008 return, an
c. 6.
exemption may be claimed for Barb if
d. 7.
a. Barb was a full-time student for the entire 2008
school year.
b. Barb attaches a written statement to Joe's income tax
11. During the year, Sam Dunn provided more than half
return, agreeing to be claimed as an exemption by
the support for his wife, his father's brother, and his
Joe for 2008.
cousin. Sam's wife was the only relative who was a
c. Barb was under the age of 19.
member of Sam's household. None of the relatives had
d. Barb had no gross income and was not claimed as
any income, nor did any of them file an individual or a
another person's dependent in 2008.
joint return. All of these relatives are U.S. citizens.
Which of these relatives should be claimed as a
dependent or dependents on Sam's return? Chapter One contains additional questions, problems
and simulations that have been omitted from this
sample chapter.

1Q-2
Excerpt from Volume 2—Regulation

Chapter One — Answers

Filing Status and Exemptions, Filing Requirements
and Penalties
1. (a) Single. A taxpayer’s filing status is determined on the last day of the taxable year. On December 31, 2008,
John and Mary were legally separated under a decree of separate maintenance and therefore, not married. Since they
did not have a child, they would not qualify as head of household. Single is the only status available.

2. (b) Husbands and wives cannot file a joint return if they have different tax years, if one is a non-resident alien, or
they were divorced as of the end of the year. They are not, however, required to use the same accounting methods.

3. (d) Single and 1 exemption. Robert does not qualify for head of household because his father does not qualify as
his dependent. His father does not qualify as his dependent because as a qualified relative he fails the gross income
test. The gross income of $4,000 from the interest income exceeds the exemption amount of $3,500 for 2008.
Social security is not a component of gross income at this income level.

4. (a) Murray qualifies as head of household because he is (1) unmarried; (2) maintains support for his mother at a
home for the aged (parents do not have to reside in the taxpayer’s home); and (3) may claim his mother as his
dependent.

5. (c) Qualifying widower with dependent child. This is sometimes referred to as surviving spouse. In the year of
death, Emil would have filed married, filing jointly. However, for the two years after that, Emil qualifies for this
status provided he (1) has not remarried and (2) maintains a home for himself and a dependent child.

6. (d) Neither I nor II. In order to qualify as qualifying widower (or surviving spouse), your child must qualify as
your dependent and must reside with you for the entire year. Also, you must maintain more than 50% of the cost of
your household for the entire year.

7. (c) 4. Mark is entitled to two personal exemptions and two dependency exemptions. Their new son qualifies
because he was born before the end of the year. His mother qualifies because he met the support test until she died
and she did not violate the gross income test. Social security benefits are not considered gross income at this
income level.

8. (b) 3. Jim and Kay may claim two personal exemptions for themselves and one dependency exemption for Dale.
The children, Dale and Kim, and the father, Grant, meet the support and relationship. Dale is not under 19, but
under 24 and is a full-time student. Therefore he is a qualified child and there is no gross income test. Kim is also
under 24, but is not a full-time student . Therefore, Kim is not a qualified child but a qualified relative and needs to
pass the gross income test. Her $12,000 in babysitting income is not less than the 2008 exemption amount of
$3,500 and she does not qualify. Grant is the parent and therefore is a qualifying relative. He has gross income of
$5,000 and does not qualify either.

9. (c) 3. The Brooks are allowed two personal exemptions and one dependency exemption for their son. Their
daughter does not qualify because of the support test. There is no exception to the support test (even though she is a
full-time student).

10. (a) 4. The Stoners are allowed two personal exemptions and two dependency exemptions for their children.
Stoner’s father does not qualify because he fails the citizenship test. Note there are no extra exemptions because the
taxpayer, or dependents are 65 and over, or blind.

11. (b) Father’s brother. This question specifically asks about the dependency exemption, not the personal. Sam’s
uncle qualifies because he satisfies the relationship test and therefore does not need to be a member of the
household. Sam’s cousin does not qualify as a dependent because he is not a relative and as a result must be a
member of the household for the entire year, which he was not.

1S-1
12. (d) Bill, Jon or Tom. Classic multiple support problem. All three sons are qualified to claim Mom as their
dependent but no one person contributes more than 50%. Since each son contributed more than 10% of her support,
each is eligible to claim her.

13. (c) Ben. Only Ben and Carl are initially qualified to claim Sara as a dependent. Ben and Carl contribute $2,600
of the $5,000 for a combined percentage of 52%. However, since Carl contributes less than 10%, he is not eligible
to claim her as a dependent. Only Ben is eligible. Note that Alma cannot be party to this arrangement because she
is not related to Sara. Sara would have to reside with Alma for the entire year in order to qualify under the
relationship test.

14. (d) By definition. This would be a personal exemption on Joe’s return.

15. (c) 2. Smith is entitled to one personal exemption and one dependency exemption for his mother Ruth. A
mother does not have to live with the taxpayer to be considered a dependent. Clay was required to file a return
(they owed additional taxes) and therefore cannot be claimed as a dependent even though the other tests were met.

16. (a) $0. Since Al and Mary were allowed to claim Doris as their dependent, Doris is not entitled to a personal
exemption for herself when she files.

17. (c) In determining the cost of maintaining the household, you would include the cost of the food consumed in
the home, as well as mortgage interest and real estate taxes (or rent), utilities and repairs. The value of services is
not included.

18. (c) Nell qualifies as head of household because she is not married, maintains a household and provides for more
than 50% of the year the cost for her child. The filing status of qualifying widow is available only for the two tax
years after the year of her husband’s death.

19. (c) April 15, 2009. The three-year statute runs from the date the return was filed, or April 15th, whichever is
later.

20. (c) April 15, 2009. The three-year statute runs from the date the return was filed, or April 15th, whichever is
later. Filing an amended return does not extend the statute of limitations.

21. (a) April 15, 2009. Whereas the taxpayer mistakenly omitted more than 25% of the gross income reported on
the return, the statute increases to six years. The six-year statute runs from the date the return was filed, or April
15th, whichever is later.

Gross income reported $ 120,000

Statute percentage 25%
Underreporting threshold $ 30,000

Amount not reported $ 45,000

22. (d) 2008. A refund claim due to worthless stock carries a seven year statute. The seven-year statute runs from
the date the return was filed, or April 15th, whichever is later.

23. (c) Form 1040X. This is the individual amended return form. Form 1139 is a claim for refund for corporations;
Form 1045 is for refunds due to operating loss carrybacks; and Form 843 is for refunds due to overpayment of
employment, gift and estate taxes.

Chapter One contains additional answers that have been omitted from this sample chapter.

1S-2
Excerpt from Volume 3—Auditing

Chapter One
Introduction, General and Field Standards
INTRODUCTION

OBJECTIVE OF THE ORDINARY EXAMINATION OF FINANCIAL STATEMENTS

To express an opinion on reliability and fairness of management prepared financial statements by means of the
auditor's report.

STANDARD SHORT-FORM AUDITOR'S REPORT—UNQUALIFIED

(Note: Audit reports are covered in detail in Chapter 3. Discussion here is for quick reference purposes only.)

The form of the standard report on financial statements covering a single year is as follows:

Independent Auditor's Report

Board of Directors
X Corporation

We have audited the accompanying balance sheet of X Company as of December 31, 20XX, and the
related statements of income, retained earnings, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our audit provides a reasonable
basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the
financial position of X Company as of (at) December 31, 20XX, and the results of its operations and its
cash flows for the year then ended in conformity with accounting principles generally accepted in the
United States of America.

(Date of completion of audit)

(Firm Name and Signature) (Italics added for emphasis)

Briefly, the auditors standard report may be modified and take one of the following forms:

Qualified Report—Usually issued when the auditor takes exception to a material item or items in the financial
statements because of departures from GAAP. A qualified opinion may also be issued when the auditor's
examination is restricted with respect to an item on the financial statements. This type of report communicates to the
reader of the financial statements that management's financial reports are fairly presented "except for" a departure
from GAAP, which is material enough to mention but not pervasive enough to render the financial statements
misleading when taken as a whole.

Adverse Report—Issued when the auditor feels that the departures from GAAP are serious enough to render the
statements misleading. In this case, the CPA was able to apply auditing procedures, but discovered material and

1-1
pervasive departures from GAAP that the client refused to correct. Thus, the dividing line between "except for"
(qualified) opinion and an adverse opinion is one of materiality and pervasiveness of the departure from GAAP.

Disclaimer Report—Issued when the auditor's examination was incomplete (scope restricted because of nature of
examination or other audit restrictions) to the point where he was unable to express an opinion on the financial
statements or where the uncertainties have a pervasive and material effect on the financial statements. Thus, a
disclaimer can result from inadequate auditing procedures or material uncertainties.

A complete discussion of the auditor's reporting function is in Chapter 3.

DISTINCTION BETWEEN RESPONSIBILITIES OF AUDITOR AND MANAGEMENT

1. Fairness of the representations contained in financial statements is part of management's responsibility.
2. Management is responsible for development of adequate controls, safeguarding of assets, sound accounting
policies that will produce proper statements (i.e., internal control).
3. Auditor's responsibility is confined to the expression of an opinion, and the adequacy of auditing procedures.
4. Purpose of the ordinary examination is not primarily the detection of fraud. Auditor is aware that fraud may
exist and as such may affect the financial statements. The auditor must assess the risk that fraud may have
affected the financial statements, and as such, the auditor would appropriately modify the audit procedures.
(See S.A.S. No. 82 for a complete discussion of the auditor's responsibility to detect fraud.)

GENERALLY ACCEPTED AUDITING STANDARDS

Auditing "standards" differ from auditing "procedures" in that procedures relate to acts to be performed, whereas
standards deal with measures of the quality of the performance of those acts and the objectives to be attained by the
use of the procedures undertaken. The generally accepted auditing standards, which are interdependent and
interrelated, are represented by the general standards, field standards, and reporting standards from the time the
Auditing Standards Board of the AICPA will issue interpretations of the standards in publications known as
Statements on Auditing Standards (SAS's).

General Standards
1. The examination is to be performed by a person or persons having adequate technical training and
proficiency as an auditor.
2. In all matters relating to the assignment an independence in mental attitude is to be maintained by the auditor
or auditors.
3. Due professional care is to be exercised in the performance of the examination and the preparation of the
report.

Standards of Field Work

1. The work is to be adequately planned, and assistants, if any, are to be properly supervised.
2. The auditor should obtain a sufficient understanding of the internal control structure to plan the audit and to
determine the nature, timing, and extent of tests to be performed.
3. Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and
confirmations to afford a reasonable basis for an opinion regarding the financial statements under examination.

Standards of Reporting
1. The report shall state whether the financial statements are presented in accordance with generally accepted
principles of accounting.
2. The report shall identify those circumstances in which such principles have not been consistently observed in
the current period in relation to the preceding period.
3. Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise
stated in the report.
4. The report shall either contain an expression of opinion regarding the financial statements, taken as a whole, or
an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed,
the reasons therefor should be stated. In all cases where an auditor's name is associated with financial
statements the report should contain a clear-cut indication of the character of the auditor's examination, if any,
and the degree of responsibility he is taking.

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OVERVIEW OF THE AUDIT PROCESS
Decision Criteria
1. Independence
Decision to Rule 101 Code
A. Accept Client of Ethics
GAAS
2. Competency
Rule 201 Code
of Ethics
GAAS
3. Predecessor Auditor
B.
Document Engagement Understanding
(Engagement Letter)

Plan Audit
C. 1. Obtain Information on: Decision on Audit Risk
a. Management a. Potential for Errors
b. Industry b. Potential for Illegal Acts
c. Regulation c. Potential for Fraud
d. Economy
e. Outside pressure

2. Perform Analytical Review

3. Initial Understanding of Internal Control
4. Audit Program
1) Preliminary based upon
1-3 and planned level of reliance on
Internal Controls
2) Detail nature, timing and extent
of Tests

Consider Internal Controls

D.
Outcomes

Plan level Confirms

of Reliance Planned
needs to level of
be modified reliance

Update Planned Go with

Audit Program original plan
Developed in as developed
C4 above in C4 above

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 E. Perform
Substantial
Audit Tests

A Extraordinary Results Nothing

1. Errors extraordinary
2. Fraud encountered
3. Illegal Acts

Update Programs
after discussions
with client

F. Obtain
Representation
Letter

G. Propose Necessary
Adjusting Entries

Rejected Accepted
By client By client

Modify Issue
opinion unqualified
appropriately opinion

DECISION TO ACCEPT A CLIENT

The decision to accept an engagement is made by reference to the General Standards of G.A.A.S. and by
consultation with the predecessor auditor, if applicable.

GENERAL STANDARDS
The general standards are concerned with the professional training and conduct of the auditor. Specifically, there are
three general standards:
1. The examination is to be performed by a person or persons having adequate technical training and
proficiency in auditing.
(This is normally interpreted to mean that the auditor has adequate formal training and a knowledge of the
accounting principles used by the client.)
2. In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor
or auditors.
(Since the auditor is attesting to the fairness of the financial statements, it is important that he have no bias
towards the client. If the CPA is not independent of his client he must disclaim an opinion.)
3. Due professional care is to be exercised in the performance of the examination and the preparation of the
report.

Chapter One contains additional text that has been omitted from this sample chapter.

1-4
Excerpt from Volume 3—Auditing

Chapter One – Questions

Introduction, General and Field Standards
1. Tests of controls are performed in order to 6. Operating control over the check signature plate
determine whether or not normally should be the responsibility of the
a. Controls are functioning as designed. a. Secretary.
b. Necessary controls are absent. b. Chief accountant.
c. Incompatible functions exist. c. Vice president of finance.
d. Treasurer.
d. Material dollar errors exist.
7. Internal control over cash receipts is weakened
2. For good internal accounting control, which of the when an employee who receives customer mail
following functions should not be the responsibility receipts also
of the treasurer's department? a. Prepares initial cash receipts records.
b. Records credits to individual accounts
a. Data processing.
receivable.
b. Handling of cash. c. Prepares bank deposit slips for all mail receipts.
c. Custody of securities. d. Maintains a petty cash fund.
d. Establishing credit policies.
8. Which of the following best describes proper
internal control over payroll?
3. During an audit an internal auditor may provide
a. The preparation of the payroll must be under
direct assistance to an independent CPA in
the control of the personnel department.
Obtaining an b. The confidentiality of employee payroll data
understanding of Performing Performing should be carefully protected to prevent fraud.
the internal tests of substantive c. The duties of hiring, payroll computation, and
control structure controls tests payment to employees should be segregated.
a. No No No d. The payment of cash to employees should be
replaced with payment by checks.
b. Yes No No
c. Yes Yes No
9. Transaction authorization within an organization
d. Yes Yes Yes may be either specific or general. An example of
specific transaction authorization is the
4. Which of the following statements regarding a. Establishment of requirements to be met in
auditor documentation of the client's system of determining a customer's credit limits.
internal control is correct? b. Setting of automatic reorder points for material
a. Documentation must include flow charts. or merchandise.
b. Documentation must include procedural c. Approval of a detailed construction budget for a
writeups. warehouse.
c. No documentation is necessary although it is d. Establishment of sales prices for products to be
desirable. sold to any customer.
d. No one particular form of documentation is
10. Effective internal control over purchases
necessary, and the extent of documentation may generally can be achieved in a well-planned
vary. organizational structure with a separate purchasing
department that has
5. It would be appropriate for the payroll accounting a. The ability to prepare payment vouchers based
department to be responsible for which of the on the information on a vendor's invoice.
following functions? b. The responsibility of reviewing purchase orders
a. Approval of employee time records. issued by user departments.
b. Maintenance of records of employment, c. The authority to make purchases of
discharges, and pay increases. requisitioned materials and services.
c. Preparation of periodic governmental reports as d. A direct reporting responsibility to the
controller of the organization.
to employees' earnings and withholding taxes.
d. Distribution of pay checks to employees.

1Q-1
11. An example of an internal control weakness is to 16. Which of the following is a primary function of
assign to a department supervisor the responsibility the purchasing department?
for a. Authorizing the acquisition of goods.
a. Reviewing and approving time reports for b. Ensuring the acquisition of goods of a specified
subordinate employees. quality.
b. Initiating requests for salary adjustments for c. Verifying the propriety of goods acquired.
subordinate employees. d. Reducing expenditures for goods acquired.
c. Authorizing payroll checks for terminated
employees.
d. Distributing payroll checks to subordinate 17. An auditor uses the knowledge provided by the
employees. understanding of internal control and the final
assessed level of control risk primarily to determine
12. The independent auditor should acquire an the nature, timing, and extent of the
understanding of a client's internal audit function to a. Attribute tests.
determine whether the work of internal auditors will b. Compliance tests.
be a factor in determining the nature, timing, and c. Tests of controls.
extent of the independent auditor's procedures. The d. Substantive tests.
work performed by internal auditors might be such a
factor when the internal auditor's work includes
a. Verification of the mathematical accuracy of 18. When control risk is assessed at the maximum
invoices. level for all financial statement assertions, an auditor
b. Review of administrative practices to improve should document the auditor's
efficiency and achieve management objectives.
Understanding Conclusion Basis for
c. Study and evaluation of internal accounting
of the entity's that control concluding
control.
internal risk is at the that control
d. Preparation of internal financial reports for
control maximum risk is at the
management purposes.
components level maximum level
a. Yes No No
13. It is important for the CPA to consider the
b. Yes Yes No
competence of the audit clients' employees because
c. No Yes Yes
their competence bears directly and importantly upon
d. Yes Yes Yes
the
a. Cost/benefit relationship of the system of
internal control.
19. Which of the following controls would be most
b. Achievement of the objectives of the system of
effective in assuring that recorded purchases are free
internal control.
of material errors?
c. Comparison of recorded accountability with
a. The receiving department compares the quantity
assets.
ordered on purchase orders with the quantity
d. Timing of the tests to be performed.
received on receiving reports.
b. Vendors' invoices are compared with purchase
14. Which of the following would be least likely to
orders by an employee who is independent of
be included in an auditor's tests of controls?
the receiving department.
a. Inspection.
c. Receiving reports require the signature of the
b. Observation.
individual who authorized the purchase.
c. Inquiry.
d. Purchase orders, receiving reports, and vendors'
d. Confirmation.
invoices are independently matched in
preparing vouchers.
15. Tests of controls are concerned primarily with
each of the following questions except
a. How were the procedures performed?
b. Why were the procedures performed? Chapter One contains additional questions,
c. Were the necessary procedures performed? problems/simulations that have been omitted from
d. By whom were the procedures performed? this sample chapter.

1Q-2
Excerpt from Volume 3—Auditing

Chapter One - Solutions to Questions

Introduction, General and Field Standards
1. (a) Tests of controls are designed to determine whether the control procedures prescribed by the client are
actually functioning. An example of a test of controls would be to examine purchase orders for proper authorization.

2. (a) Data processing is a recording function and thus should be under the direction of the controller. Answers (b),
(c) and (d) are functions of the treasurer's department since they are "custodial" in nature.

3. (d) In performing an audit, the CPA may request direct assistance from internal auditors. For example, internal
auditors may assist the independent CPA in obtaining an understanding of the internal control structure or in
performing tests of controls or substantive tests.

4. (d) The auditor is required to assess the internal control structure as part of the audit process. The documentation
provides evidence that the auditor has complied with the second standard of field work. The extent and type of
documentation is left to the auditor's judgment.

5. (c) This department has access to the records necessary to prepare payroll tax reports.

6. (d) Treasurer is responsible for cash disbursements.

7. (b) There is a control weakness because the employee has both custody of an asset (cash) and the accounting
record (accounts receivable subsidiary ledgers).

8. (c) The authorization of transactions, record keeping, and custodial functions should be segregated.

9. (c) Special authorization refers to a certain item. General authorization refers to classes of items.

10. (c) Purchasing agent has authority to purchase, not authority to initiate purchases.

11. (d) Department supervisor authorizes payroll and should not be responsible for distribution (custodial
function—custody of checks).

12. (c) The work of internal auditors is a part of, but not a substitute for, the independent auditor's evaluation of
internal control. Answer (a) is work not necessarily performed by internal auditors. Answers (b) and (d) do not
directly affect internal accounting control.

13. (b) One of the basic elements of an adequate system of internal control is competent personnel with clear lines
of authority and responsibility.

14. (d) Inquiry is the first step in determining the client's control system. The system is then tested by applying the
procedures detailed in answers (a) and (b). Answer (d) is used to verify balances, not test controls.

15. (b) The question deals with the primary questions asked in testing controls. The auditor is least concerned with
why. He performs the procedures because he is concerned with control which centers primarily on how, where and
who, as opposed to why (this is answered in the understanding of the system).

16. (b) The purchasing department's function is solely to purchase previously authorized goods and services at the
desired quality and best price. They have no function in authorization for purchase receiving or payment.

1S-1
17. (d) Substantive tests are audit tests performed to substantiate the fairness of presentation of each account on the
financial statements. The nature, timing, and extent of substantive tests is determined by the creditor's assessment of
control risk. Answers (a), (b) and (c) are synonymous terms, and these tests are used to determine whether internal
control procedures are actually in place in the client's operation.

18. (b) GAAS requires that the auditor understand the entity's control structure elements and to document the
assessed level of control risk. If control risk is assessed at the maximum, no reasons need to be stated. However, if
control risk is assessed at less than the maximum, the reasons for assessing it at less than the maximum must be
documented.

19. (d) In order to prevent material errors in recording purchases, an employee who is independent of the purchasing
or receiving function should compare the quantity purchased with the quantity received and the quantity billed by
the vendor. This is the function of the accounts payable clerk.

20. (b) A material weakness is a condition where control procedures are not suitably designed or operating
effectively to prevent or detect an error or irregularity in the normal course of business by employees performing
their assigned duties. Therefore, accounting records and financial statements may be incorrect. A reportable
condition is a situation in the control structure that may be designed ineffectively or not operating properly, but the
deficiency has no effect on the timely recording and summarizing accounting transactions. According to GAAS,
both situations a material weakness and a reportable condition are reportable conditions, but a reportable condition
may not be a material weakness.

21. (c) Answers (a), (b) and (d) are incorrect because the auditor can ascertain that these controls are in place by
other means through records available within the company. However, in order to determine whether a given
employee actually exists, the auditor must observe the actual distribution of checks and would usually include the
employee providing some form of personal identification.

22. (b) The auditor may document his understanding of the client's internal control through the use of a narrative,
internal control questionnaire or flowchart or any other appropriate means. Therefore, answer (b) is the correct
answer.

23. (a) The purpose of tests of controls is to provide reasonable assurance that internal controls are being applied as
determined by the auditor during the review of the internal control structure.

24. (b) The payroll accounting department has a recording responsibility and as such it should not have custody of
unclaimed payroll checks (custody of an asset). If the payroll accounting department had custody of payroll checks,
its employees could add a fictitious employee to the payroll and subsequently obtain the check.

25. (a) In an organizational structure, the personnel department is delegated the authorization power over pay rates.

26. (d) In order to evaluate the objectivity of internal auditors, it is necessary for the independent CPA to determine
the organizational level to which the internal auditor reports. If, for example, the internal auditor reports to the
controller, it would be impossible for the internal auditor to be objective.

27. (b) The receiving department copy of the purchase order should be "blind" (i.e., quantities omitted). This
ensures that the receiving department personnel count the incoming merchandise. Thus the company will end up
paying only for what was received, which may not be what was billed by the vendor.

28. (a) Control procedures over the payroll function include the reconciliation of job time tickets to employee clock
card hours. Answer (b) is incorrect because the reconciliation should be done by the payroll department, not the
individual employee responsible for those jobs.

Chapter One contains additional answers that have been omitted from this sample chapter.

1S-2
Excerpt from Volume 4—Business Environment and Concepts

Chapter Three
Microeconomics with Strategy Emphasis
Market Influences on Business Strategies, Including Selling, Supply Chain,
and Customer Management Strategies

An understanding of micro-economics (the economics of the firm) starts with an understanding of the demand and
supply curves and their intersection to determine the equilibrium price. Let us review by examining a family’s
demand curve for a commodity product such as milk in a regional marketing area such as New York City. The graph
below illustrates the demand curve.

Demand Curve for Milk in New York City

Price Graph A

$6.00

$5.50

$5.00

$4.50

$4.00

$3.50

$3.00

$2.00

$1.50 D

2 4 6 8 10 12 14 16
Gallons per Month

The demand curve in graph A, above is illustrated by the line that is downward sloping to the right (D). The demand
curve is downward sloping because of the law of diminishing marginal utility. The law of diminishing marginal
utility recognizes that the total satisfaction derived from the consumption of milk (or any good) will initially
increase as more of the good is consumed and then total satisfaction will start to diminish. The diminishing total
satisfaction is reflected in the demand curve in that as the quantity per month increases, the consumer will be willing
to pay less for the next additional unit of the good. The consumer might be willing to pay $3.50 per gallon for 8
gallons of milk per month, but would only be willing to purchase the ninth gallon of milk per month at some price
less than $3.50 per gallon.

From a strategic viewpoint, businesses seek to shift the demand curve to the right in order to sell a larger quantity at
the same price or the same quantity at a higher price. The various ways that a demand curve might shift to the right
are the following:
1. Increase in the number of consumers
2. A change in tastes in favor of the good
3. Increase in the price of substitutes
4. An increase in the income of consumers

3-1
 A shift in the demand curve should be contrasted with a change in quantity demanded on the same demand
curve. A shift in the demand curve to the right signals that at each price point the consumer is willing to
buy a larger quantity of the good. On the other hand, a change in quantity demanded refers to a change in
demand on a particular demand curve. A change in quantity demanded may be illustrated by reference to
graph A. Given the demand curve in graph A, a change in price from $3.50 per gallon to $3.00 per gallon
will result in an increase in quantity demanded from 8 gallons per month to 10 gallons per month. Thus, the
term “change in quantity demanded” does not refer to a situation in which the demand curve has shifted.
Graph B below illustrates the shift in the demand curve from D to D1.

Demand Curve for Milk in New York City

Price Graph B

$6.00

$5.50

$5.00

$4.50

$4.00

$3.50

$3.00

$2.00 D1
$1.50
D

2 4 6 8 10 12 14 16
Gallons per Month

When you contrast demand curve D with demand curve D1, it is clear that for all price points the quantity demanded
is greater for demand curve D1 than it is for demand curve D. That demand curve shift to the right could have been
caused by any of the four causes mentioned earlier.

The slope of the demand curve is of particular importance from a strategic perspective. Demand curves tend to be
either elastic or inelastic. An elastic demand curve suggests that a small percentage change in price will result in a
larger percentage change in quantity demanded. Using the demand curve in graph A, we can calculate the price
elasticity of demand for the situation in which the price declines from $3.50 per unit to $3.00 per unit. Graph A
shows that the quantity of 8 gallons is associated with the $3.50 per gallon price and the quantity of 10 gallons is
associated with the $3.00 price. The coefficient of the price elasticity of demand for that portion of the demand
curve is calculated using the following equation:

Percentage change in quantity / Percentage change in price

The decline in price from $3.50 to $3.00 results in a $.50 change in price. That represents the following percentage
change in price:

$.50 / Average of $3.50 and $3.00 =

$.50 / $3.25 = 15.38%

3-2
The increase in quantity from 8 gallons (associated with the $3.50 price) to 10 gallons (associated with the $3.00
price) represents the following percentage change in quantity demanded:

2 gallon change / Average of 8 gallons and 10 gallons =

2 gallons / 9 gallons = 22.22%

Therefore the price elasticity of demand is

22.2% change in quantity / 15.38% change in price = 1.44

Therefore the coefficient of the price elasticity of demand for that price change is 1.44. A coefficient greater than
one suggests an elastic demand curve and a coefficient less than one suggests an inelastic demand curve.

It is important to remember that the equation for calculating the coefficient of the price elasticity of demand has the
Quantity on the top and the Price on the bottom. To help you remember, think of a man that has his tie tied too
tightly. It is so tight that his tongue is hanging out as in Q for quantity. The P (price) represents the tie around his
neck.

Inelastic demand is represented by a coefficient of price elasticity of demand that is less than 1. In such a situation
the demand curve would tend to be more vertical than the one shown in graph A. The demand curve for coffee
would likely be more vertical than the demand curve for milk given that there is more of a tendency for the caffeine
in coffee to be slightly addictive. The inelastic demand curve suggests that a large percentage change in price will
result in a relatively small percentage change in quantity demanded.

The difference between elastic and inelastic demand may also be examined in terms of the total revenue before and
after a price change. In the example in which the price changed from $3.50 to $3.00, the quantity changed from 8
gallons to 10 gallons. The revenue associated with the $3.50 price was $28 ($3.50 X 8 gallons) and the revenue
associated with the $3.00 price was $30 ($3.00 X 10 gallons). Thus, for this relatively elastic demand curve (in the
interval of $3.50 to $3.00 per gallon) illustrated in graph A, the decline in price resulted in an increase in revenue by
$2. ($30- $28). This focus on revenues permits us to draw the following conclusions concerning the relationship
between revenue and price elasticity of demand:

If the demand curve… and… then…

Is elastic Price falls Revenue increases
Is elastic Price rises Revenue decreases
Is inelastic Price falls Revenue decreases
Is inelastic Price rises Revenue increases

Demand is more elastic for goods that have multiple substitutes and less elastic for goods with relatively few
substitutes. A strategy used by many companies is one that attempts to convince potential customers that the
company’s product is sufficiently differentiated from other products that there is no suitable substitute product. The
company is attempting to create a relatively inelastic demand curve for the product. An inelastic demand curve
would permit the company to increase price and thus increase revenues. In contrast, an elastic demand curve would
result in a decrease in revenues if price were increased.

Demand also tends to be more inelastic in the short run because it takes time to identify suitable substitutes. Thus,
the demand for a product tends to be more elastic in the long run than it is in the short run. Thus, a strategy of raising
prices to take advantage of a relatively inelastic demand curve in the short run could be counterproductive. The
higher prices could attract competitors and the competitors would offer suitable substitute products. In the long run,
the demand curve could become elastic because of the increased substitutes. Thus, the exploitation of an inelastic
demand curve may only be profitable in the long term if the company can sustain a competitive advantage.

High value products are more likely to have elastic demand curves than are low value products. For high value
products, such as automobiles, the consumer is more likely to shop around for substitute products because the
potential savings associated with “shopping around” are likely to be great. On the other hand, the potential savings
from shopping around for low value products, such as candy bars, is not nearly as great.

3-3
Now that we have dealt with the demand curve, it is time to turn to the supply curve. The supply curve slopes
upward and to the right as shown in graph C. The intersection of the demand and supply curves is at a price of $3.50
and a quantity of 8 gallons per month. The intersection of the demand and supply curves is called the “price
equilibrium point” and it determines the price at which the good will be sold and the quantity which will be sold.

Demand and Supply Curves for Milk in New York City

Price Graph C

$6.00

$5.50 S
$5.00

$4.50

$4.00

$3.50

$3.00

$2.00

$1.50 D

2 4 6 8 10 12 14 16
Gallons per Month

The supply curve slopes upward as a result of the tendency for marginal costs to increase as the quantity produced
increases. The law of diminishing returns is the basis on which marginal costs increase. Given a fixed amount of
production resources (equipment and buildings), the addition of increments of labor will produce diminishing
returns. Those diminishing returns translate into higher marginal costs as the quantity increases. Thus, with
increasingly higher marginal cost, a producer would only be induced to produce a larger quantity if the price of the
product were sufficiently high. The price has to exceed the marginal cost of the next unit of product produced in
order to induce the producer to supply a larger quantity.

Just like demand curves, supply curves may shift to the right or to the left. A shift to the right implies that a larger
quantity will be supplied for every price point on the supply curve. A shift to the left implies that a smaller quantity
will be supplied for every price point on the supply curve. Listed below are the various causes of a supply curve
shift:

• Price of input resources – if the price of input resources declines, the marginal cost declines and the supply
curve will shift to the right. A larger quantity will be offered at each price point.

• Number of suppliers – if the number of suppliers increases, the supply curve will shift to the right. In this
case, the marginal cost has not changed but more is supplied because of a greater number of suppliers.

Chapter Three contains additional text that has been omitted from this sample chapter.

3-4
Excerpt from Volume 4—Business Environment and Concepts

Chapter Three
Microeconomics with Strategy Emphasis
Multiple Choice Questions1

1. The demand for a good or service depends on all 5. When building contractors decide not to build on
the following factors EXCEPT: speculation but only when a contract to build is
a. The cost to produce it. executed, it is a signal that wage inflation may be
b. The price of the item. causing a rise in building costs. One may conclude
c. The tastes of consumers. from this scenario that:
d. The prices of substitute and complementary a. The supply curve will remain static as wage
goods. inflation increases demand.
b. The quantity of new homes demanded will
decrease, prices will rise, and the supply curve
2. Which of the following statements concerning the will shift to the left.
relationship of the quantity demanded or supplied c. The supply curve will shift downward but prices
with price is (are) correct? will rise.
(1) The quantity supplied varies inversely with price. d. The quantity of homes built will decrease along
(2) The quantity demanded varies directly with price. with the price of housing.
a. (1) only
b. (2) only
6. Supply Chain Management systems rely upon
c. Both (1) and (2)
which of the following?
d. Neither (1) nor (2)
a. Many suppliers.
b. Frequent competitive bidding.
c. Cooperation between purchasing and suppliers.
3. According to economic theory, which of the
d. Short-term contracts.
following statements is correct?
a. A price in excess of the equilibrium price would
lead to a shortage of supply.
7. If both the supply and the demand for a good
b. A price in excess of the equilibrium price would
increase, the market price will
lead to an excess of demand.
a. rise only in the case of an inelastic supply
c. An equilibrium price can be disrupted by a
function.
rightward or leftward shift of the supply or
b. fall only in the case of an inelastic supply
demand curve.
function.
d. An equilibrium price is the price at which all
c. not be predictable with only these facts.
consumers are able to buy as much as they want.
d. rise only in the case of an elastic demand
function.
4. A shift in the supply curve downward and to the
right, with the demand curve unchanged, will lead to
8. The sum of the average fixed costs and the
which of the following results?
average variable costs for a given output is known as
(1) An increase in the equilibrium price
a. long-run average cost.
(2) A decrease in the equilibrium quantity
b. average product.
a. (1) only c. total cost.
b. (2) only d. average total cost.
c. Both (1) and (2)
d. Neither (1) nor (2)

1
Material from Economics (Bank 1 t/a) by McConnell, published by McGraw Hill,
copyright ©2002, is reproduced with permission of the McGraw-Hill Companies.

3Q-1
9. In any competitive market, an equal increase in
both demand and supply can be expected to always
a. increase both price and market-clearing quantity.
b. decrease both price and market-clearing quantity.
c. increase market-clearing quantity.
d. increase price.
10. A perfectly inelastic supply curve in a
competitive market
a. means the equilibrium price must be zero.
b. says the market supply curve is horizontal.
c. exists when firms cannot vary input usage.
d. can only exist in the long run.
11. Government price regulations in competitive
markets that set maximum or ceiling prices below the
equilibrium price will in the short run
a. cause demand to decrease.
b. cause supply to increase.
c. create shortages of that product.
d. have no effect on the market.
12. In competitive product markets, equilibrium price
in the long run is
a. a fair price all consumers can afford.
b. set equal to the total costs of production.
c. set equal to the total fixed costs of production.
d. set equal to the marginal costs of production.
13. In the theory of demand, the marginal utility per
dollar of a product
a. increases when consumption expands.
b. decreases when consumption expands.
c. is used to explain why demand curves are
vertical.
d. explains why short-run supply curves are upward
sloping.
14. In the short run, the supply curve in a competitive
market shows a positive relationship between price
and quantity supplied because
a. a higher price causes an increase in demand so
the market stays in equilibrium.
b. of the law of diminishing returns.
c. as the size of a business firm increases, price
must rise.
d. increases in output imply a shift in consumer
preferences allowing a higher price.
3Q-2
15. Because of the existence of economies of scale,
business firms may find that
a. each additional unit of labor is less efficient than
the previous unit.
b. as more labor is added to a factory, increases in
output will diminish in the short run.
c. increasing the size of a factory will result in
lower average costs.
d. increasing the size of a factory will result in
lower total costs.
16. Economic markets that are characterized by
monopolistic competition have all of the following
characteristics EXCEPT
a. one seller of the product.
b. economies or diseconomies of scale.
c. heterogeneous products.
d. downward-sloping demand curves for individual
firms.
17. When markets are perfectly competitive,
consumers
a. must search for the lowest price for the products
they buy.
b. have goods and services produced at the lowest
cost in the long run.
c. must choose the brands they buy solely on the
basis of informational advertising.
d. do not receive any consumer surplus unless
producers choose to overproduce.
18. The manner in which cartels set and maintain
price above the competitive market price is to
a. avoid product differentiation in order to decrease
demand for the product.
b. advertise more so market demand increases.
c. encourage the introduction of higher-priced
substitute products.
d. require cartel members to restrict output.
19. In a competitive market for the labor where
demand is stable, if workers try to increase their
wage,
a. employment must fall.
b. labor supply must increase.
c. government must set a maximum wage below
the equilibrium wage.
d. firms in the industry must become smaller.
Chapter Three contains additional questions that
have been omitted from this sample chapter.
Excerpt from Volume 4—Business Environment and Concepts

Chapter Three
Microeconomics with Strategy Emphasis
Answers to Multiple Choice Questions
1. Answer (a) is the correct answer. The cost to produce an item is a determinant of the supply curve for the item.
Answer (b) is not correct because the price of the item is a determinant of the demand for an item. Answer (c) is not
correct because the tastes of the consumer is a determinant of demand. Answer (d) is not correct because the prices
of substitute and complementary goods is a determinant of demand.

2. Answer (d) is the correct answer. The quantity supplied varies directly with price and the quantity demanded
varies indirectly with price. Answer (a) is not correct because the quantity supplied varies directly with price.
Answer (b) is not correct because the quantity demanded varies indirectly with price. Answer (c) is not correct
because the quantity supplied varies directly with price and the quantity demanded varies indirectly with price.

3. Answer (c) is the correct answer. An equilibrium price can be disrupted by any change in the supply and or the
demand curve. Answer (a) is not correct because such a price would lead to a surplus. Answer (b) is not correct
because such a price would lead to a deficiency in demand. Answer (d) is not correct because an equilibrium price
leads to an equality of the quantities demanded and supplied, not necessarily (or even likely) a complete satisfaction
of consumer demand for the good or service.

4. Answer (d) is the correct answer. A downward and to the right shift in the supply curve with no change in the
demand curve will result in a lower price and a larger equilibrium quantity. Answer (a) is not correct because a
downward and to the right shift in the supply curve with no change in the demand curve will decrease the
equilibrium price. Answer (b) is not correct because a downward and to the right shift in the supply curve with no
change in the demand curve will result in an increase in the equilibrium quantity. Answer (c) is not correct because a
downward and to the right shift in the supply curve with no change in the demand curve will result in a lower price
and a larger equilibrium quantity.

5. Answer (b) is the correct answer. The supply curve will shift to the left, the demand curve will remain unchanged,
prices will increase and the quantity demanded will decline. Answer (a) is not correct because the supply curve will
shift to the left and speculative homes are no longer built. Answer (c) is not correct because a downward shift in the
supply curve would suggest an increased supply at all price points (contrary to the removal of speculative homes)
and an increased supply would imply a reduction in price. Answer (d) is not correct because the supply curve will
shift to the left as speculative homes are no longer constructed. That shift in the supply curve with no change in the
demand curve will result in an increase in price.

6. Answer (c) is the correct answer. Supply Chain Management systems are based on purchasers and suppliers
working together under long-term contracts to reduce the cost of the product or service and also to reduce the cost of
the delivery and documentation. Answer (a) is not correct because under Supply Chain Management systems
purchasing managers establish partnerships with one or few suppliers. Answer (b) is not correct because under
Supply Chain Management systems the purchasing manager and the supplier enter into a long-term contract to
induce the supplier to participate as a partner with the purchaser. Answer (d) is not correct because in order to
establish a partnership between the purchaser and the supplier, there is a need for long-term contracts.

7. (c) is the correct answer. The effect on the market price will only be predictable when the extent of the change in
demand or supply is known. That information is not given among the choices. Answer (a) is not correct because the
increase in supply is inconsistent with an inelastic supply function. Answer (b) is not correct because the increase in
supply is inconsistent with an inelastic supply function. Answer (d) is not correct because the increase in demand is
inconsistent with an inelastic demand function.

3S-1
8. (d) is the correct answer. Explicit costs are of two types—fixed costs and variable costs. The sum of the average
fixed costs and average variable costs is equal to the average total costs. Answer (a) is not correct because the long-
run average cost includes opportunity costs. Answer (b) is not correct because average product is the total physical
product divided by the number of units of the factor employed. Answer (c) is not correct because the total cost is the
sum of the total variable costs and the total fixed costs.

9. (c) is the correct answer. The market clearing quantity is the quantity purchased which leaves no frustrated
consumers. If the increase in both demand and supply were equal, that increase in supply would be purchased and
there would be no frustrated consumers. Thus, the quantity purchased would increase. Answer (a) is not correct
because it is not likely that the price would increase because the supply increased. Answer (b) is not correct because
it is not likely that the price would decrease because the demand increased. Answer (d) is not correct because both
demand and supply increase equally.

10. (c) is the correct answer. A perfectly inelastic supply curve is a vertical line; and it implies that a change in price
will not impact the quantity offered in the market. That would be the case where firms cannot vary input usage.
Answer (a) is not correct because an equilibrium price of zero would mean that it is a free good. Answer (b) is not
correct because a horizontal supply curve is used to represent a perfectly elastic supply curve, not an inelastic one.
Answer (d) is not correct because a perfectly inelastic supply curve is more likely to occur in the short run, than in
the long run. In the long run, producers may be able to adjust to lower or higher demand for the product.

11. (c) is the correct answer. If the maximum price is set below the equilibrium price, the supply will not be
sufficient to meet the demand. Thus, there will be a shortage of the product. Answer (a) is not correct because
demand is independent of supply. Answer (b) is not correct because supply will not increase if the market-clearing
price cannot be realized. Answer (d) is not correct because regulations that set minimum prices are likely to have an
impact on the market in most situations.

12. (d) is the correct answer. In a competitive market, the forces of demand and supply will, in the long run, cause
price to equal marginal cost. If price is higher than marginal cost, additional production will be forthcoming. If price
is lower than marginal cost, producers will quit producing. Answer (a) is not correct because a competitive market
cannot assure a fair price that all consumers can afford. The disposable income of the consumers dictates whether or
not they can afford the product at the equilibrium price. Some will be able to afford it and some will not. Answer (b)
is not correct because a price set equal to the total cost of production fails to recognize that the total cost should be
divided by the number of units produced. Answer (c) is not correct because a price set equal to the total fixed cost of
production fails to recognize that the total fixed cost should be divided by the total number of units produced. Even
then, the variable costs per unit would be ignored.

13. (b) is the correct answer. The principle of diminishing marginal utility states that additional utility declines as
quantity consumed increases. Answer (a) is not correct because the principle of diminishing marginal utility states
just the opposite is true. One tires of something the more he or she has of it. Answer (c) is not correct because a
vertical demand curve implies that the demand remains unchanged as price changes. That is contrary to the principle
of diminishing marginal utility. Answer (d) is not correct because it implies that marginal utility increases as supply
increases. Utility is independent of supply.

14. (b) is the correct answer. In the short run the addition of variable inputs to fixed resources yields additional
output; but the amount of additional output diminishes as more variable inputs are used. Thus, as price increases, the
amount of product supplied will increase until the marginal cost is equal to the marginal revenue. Answer (a) is not
correct because a higher price does not usually cause an increase in demand. The increase in demand is what would
likely cause a higher price. Answer (c) is not correct because as the size of the business firm increases, the price
must fall if the demand remains unchanged. Answer (d) is not correct because increases in supply do not always
imply a shift in consumer preference; it could be caused by the entry of a new producer in pursuit of excess profits.

15. (c) is the correct answer. Economies of scale are declines in long-run average costs that are caused by increased
plant size. Answers (a) and (b) are not correct because they describe the law of diminishing returns. Answer (d) is
not correct because increasing the size of the factory might lower average costs, but it will not lower total costs.

Chapter Three contains additional answers that have been omitted from this sample chapter.

3S-2
 Course Book Contents
Case examples, illustrations ... over 2,000 pages ... over 2,400 questions and
problems/simulations from recent CPA examinations. Includes explanations of solutions
to multiple choice questions, problems/simulations.

VOLUME 1—Financial Accounting and Reporting

Partnerships
Stockholders’ Equity and Investments in Stock
Inventories
Consolidated Financial Statements
Earnings Per Share, Segment Reporting
Price Level—Foreign Exchange
Accounting Theory
Statement of Cash Flows (FASB #95), Financial Statement Analysis
Bonds, Accounting for Debt
Revenue and Expense Recognition; Miscellaneous Items
Other Assets, Liabilities and Disclosures
Reporting the Results of Operations
Accounting for Income Taxes
Accounting for Leases, Pension and Postretirement Plans
Governmental Accounting
Not-for-Profit Accounting

VOLUME 2—REGULATION
Business Law and Professional Responsibilities: Federal Income Taxes:
• Contracts • Filing Status and Exemptions, Filing Requirements and
• Sales Penalties
• Secured Transactions • Income—Inclusions and Exclusions
• Negotiable Instruments • Deductions for Adjusted Gross Income
• Documents of Title • Deductions from Adjusted Gross Income
• Agency • Accounting Methods and Periods, and Computation of Tax
• Bankruptcy Liability and Credits
• Surety and Debt Collection Remedies • Capital Transactions
• Property • Partnerships
• Insurance • C Corporations
• Securities Acts and Antitrust Regulation • Corporate Distributions, S Corporations and Other Corporate
• Regulation of Employment Matters
• Accountant's Legal Liability • Taxation of Gifts, Estates and Fiduciaries, and Exempt
• Professional Responsibility Organizations

VOLUME 3—AUDITING
Introduction, General and Field Standards
The Third Standard of Field Work—Evidence
Standards of Reporting
Attestation Standards, Government Auditing Standards, Quality Control Standards
Reviews, Compilations, Special Reports and Other Reports
The Audit Sampling Process
Auditing with Technology

VOLUME 4—Business ENVIRONMENT and CONCEPTS

• Non-Corporate Entities • Financial Statement Implications of Liquid Asset Management
• Corporations • Information Technology Implications in the Business Environment
• Microeconomics with Strategy Emphasis • Cost Accounting: Actual Cost, Job Order and Process
• Business Cycles • Cost Accounting: Joint Products and Standard Costs
• Economic Measures • Managerial Analysis and Control
• Foreign Exchange • Managerial Planning and Control
• Financial Modeling
• Strategies for Short- and Long-Term Financing Options
 Lambers CPA Review classes are offered
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